11 making informed judgments part 5 risks and rewards application: shopping mall exercise and...

11

Making Informed Judgments

Part 5

Risks and Rewards Application:

Shopping Mall Exercise and 2007-2009 Credit Crisis

Navigating Accounting,® G. Peter & Carolyn R. Wilson, © 1991-2009 NavAcc LLC. Modified by [Your Name].

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Shopping Mall Exercise:

Two shareholders

One shareholder and one bank loan

One shareholder and two bank loans

Closing thoughts

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33

Mall Exercise: Two Shareholders

On 01/01/2009, ABC Company is formed and issues stock to two shareholders

$200 worth of stock to shareholder A (20%)

$800 worth of stock to shareholder B (80%)

On 01/02/2009, ABC purchases land for $1,000

Land is next to a planned shopping mall

Mall still needs approval from regulators

ABC expects to resale the land at the end of 2009:

For $2,000 if the shopping mall is approved by regulators

For $500 if the shopping mall is not approved

Things You Need to Know

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44


On 12/28/2009, ABC learns whether the mall is approved or not

On 12/30/2009, ABC sells the land

For $2,000 if the mall is approved

For $500 if the mall is not approved

On 12/31/2009, ABC distributes the cash from the sale of the land to its shareholders. The payoffs are in proportion to the shareholder’s equity stake in the company.

ABC is located in a country where there are no taxes.


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55


Determine ABC’s balance sheet possibilities:

Question: Part a1

ABC Company Consolidated Balance Sheet1/2/2009 1/1/2009

If Mall approved

If Mall not approved

After land purchased

After financing

Assets

Cash and equivalents

PP&E

Total assets

Liabilities and stockholders' equity

Debt

Stockholders' equity:

Common stock

Retained earnings

Total stockholders' equity

Total liabilities and stockholders' equity

12/30/2009, Pre Payoffs

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66


ABC’s balance sheet possibilities:

Solution: Part a1

Consolidated Balance Sheet1/2/2009 1/1/2009

Mall approved

Mall not approved

After land acquired

After financing

Assets


PP&E

Total assets


Debt


Common stock

Retained earnings




$0 $1,000

$1,000 $0

$1,000 $1,000

$0 $0

$1,000 $1,000

$0 $0

$1,000 $1,000

$1,000 $1,000

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77


How did the land purchase affect the balance sheet?

Why would an investor want to know about this change?

Question

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88


Determine ABC’s shareholders’ gain/loss possibilities:

Question: Part a2

MallApprov

MallNot Approv

MallApprov

MallNot Approv

Part (a)

Investment

Payoff

Gain/Loss

SHAREHOLDERS

A B

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ABC’s shareholders’ gain/loss possibilities:

Solution: Part a2

MallApprov

MallNot Approv

MallApprov

MallNot Approv

Part (a)

Investment $200 $200 $800 $800

Payoff $400 $100 $1,600 $400

Gain/Loss $200 ($100) $800 ($400)

SHAREHOLDERS

A B

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1010



Solution: Part a3

Consolidated Balance Sheet1/2/2009 1/1/2009

Mall approved

Mall not approved

After land acquired

After financing

Assets


PP&E

Total assets


Debt


Common stock

Retained earnings




$2,000 $500 $0 $1,000

$0 $0 $1,000 $0

$2,000 $500 $1,000 $1,000

$0 $0 $0 $0

$1,000 $1,000 $1,000 $1,000

$1,000 ($500) $0 $0

$2,000 $500 $1,000 $1,000

$2,000 $500 $1,000 $1,000

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1111


The possible downside looks pretty bleak for both shareholders at the time they invest in ABC.

They lose a good deal of their investments if the mall is not approved.

Without additional information, we can’t conclude how risky the investment is:

To quantify the shareholders’ risks, we would need to know their beliefs about the likelihood that the mall would be approved when they invested in ABC.

For example, their perceived risk would be much greater if they believed there was a 1% chance of approval versus a 95% chance of approval.

Take Away

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1212


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Compare the risks of Intel’s cash & cash equivalents, inventories, and property, plant and equipment.

INTEL CORPORATIONCONSOLIDATED BALANCE SHEETS

December 27, 2008 and December 29, 2007(In Millions--Except Par Value) 2008 2007AssetsCurrent assets:

Cash and cash equivalents 3,350$ 7,307$ Short-term investments 5,331 5,490 Trading assets 3,162 2,566 Accounts receivable, net of allow ance for doubtful accounts of $17 ($27 in 2007) 1,712 2,576 Inventories 3,744 3,370 Deferred tax assets 1,390 1,186 Other current assets 1,182 1,390

Total current assets 19,871 23,885 Property, plant and equipment, net 17,544 16,918 Marketable equity securities 352 987 Other long-term investments 2,924 4,398 Goodwill 3,932 3,916 Other long-term assets 6,092 5,547

Total assets 50,715$ 55,651$

Intel's 2008 Form 10-K, page 57. www.sec.gov

See accompanying notes in the 10-K.

Question

1313


Determine ABC’s shareholders’ expected returns at the time the land is purchased assuming they believe there is a 50% chance the mall will be approved.

Question: Part a4

MallApprov

MallNot Approv

ExpectedMall

ApprovMall

Not ApprovExpected

Part (a)

Investment $200 $200 ▬ $800 $800 ▬

Probability 50% 50% ▬ 50% 50% ▬

Payoff $400 $100 $1,600 $400

Gain/Loss $200 ($100) $800 ($400)

%Return on investment

SHAREHOLDERS

A B

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1414


ABC’s shareholders’ expected returns:

Solution: Part a4

MallApprov

MallNot Approv

ExpectedMall

ApprovMall

Not ApprovExpected

Part (a)

Investment $200 $200 ▬ $800 $800 ▬

Probability 50% 50% ▬ 50% 50% ▬

Payoff $400 $100 $1,600 $400

Gain/Loss $200 ($100) $800 ($400)

%Return on investment

SHAREHOLDERS

A B

$250 $1,000

$50 $200

100% -50% 25% 100% -50% 25%

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1515


Without additional information, we can’t determine whether the 25% expected return is reasonable given the related risks:

To this end, the shareholders would need to compare this investment to expected returns on other investment opportunities with comparable risk.

At the time of the purchase, the two shareholders could have different assessments of the probability that the mall would be approved, and thus, different assessments of the payoffs. Additionally, their assessments could differ from those of ABC’s management.

As a result, the three parties’ perceptions about the related risks and the reasonableness of the investment could differ.

Take Away

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1616

Mall Exercise: One Shareholder & One Bank

On 01/01/2009, ABC Company:

Issues $200 worth of stock to shareholder A

Issues $800 worth of debt to First Bank with 10% per year interest

On 01/02/2009, ABC purchases land for $1,000

Next to planned shopping mall



For $2,000 if mall approved

For $500 if mall not approved


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1717


On 12/28/2009, ABC learns whether mall is approved



For $500 if mall not approved

On 12/31/2009, ABC distributes its cash to investors


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1818



Question: Part b1


If Mall approved



After financing

Assets


PP&E

Total assets


Debt


Common stock

Retained earnings




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Solution: Part b1

Consolidated Balance Sheet12/30/2009, Pre Payoffs 1/2/2009 1/1/2009

Mall approved

Mall not approved

After land acquired

After financing

Assets


PP&E

Total assets


Debt


Common stock

Retained earnings



$0

$1,000

$1,000

$800

$200

$0

$200

$1,000

$1,000

$0

$1,000

$800

$200

$0

$200

$1,000

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2020



Question: Part b2

Approv Not Approv Approv Not Approv Approv Not Approv

Part (a)

Investment ─ ─ $200 $200 $800 $800

Payoff ─ ─ $400 $100 $1,600 $400

Gain/Loss ─ ─ $200 ($100) $800 ($400)

Part (b)

Investment $800 $800 $200 $200 ─ ─

Payoff ─ ─

Gain/Loss ─ ─

BANKS SHAREHOLDERSFirst A B

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2121


Part (a)

Investment ─ ─ $200 $200 $800 $800

Payoff ─ ─ $400 $100 $1,600 $400

Gain/Loss ─ ─ $200 ($100) $800 ($400)

Part (b)

Investment $800 $800 $200 $200 ─ ─

Payoff ─ ─

Gain/Loss ─ ─




Solution: Part b2

$880 $500 $1,120 $0

$80 ($300) $920 ($200)

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2222



Solution: Part b3

Consolidated Balance Sheet12/30/2009, Pre Payoffs 1/2/2009 1/1/2009

Mall approved

Mall not approved

After land acquired

After financing

Assets


PP&E

Total assets


Debt


Common stock

Retained earnings



$2,000

$0

$2,000

$500

$0

$500

$880 $500

$200 $200

$920 ($200)

$1,120 $0

$2,000 $500

$0

$1,000

$1,000

$800

$200

$0

$200

$1,000

$1,000

$0

$1,000

$800

$200

$0

$200

$1,000

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2323


What has not changed in part (b) versus part (a)?

What has changed? Why?

Question: Part b4


Part (a)

Investment ─ ─ $200 $200 $800 $800

Payoff ─ ─ $400 $100 $1,600 $400

Gain/Loss ─ ─ $200 ($100) $800 ($400)

Part (b)

Investment $800 $800 $200 $200 ─ ─

Payoff $880 $500 $1,120 $0 ─ ─

Gain/Loss $80 ($300) $920 ($200) ─ ─


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2424


The asset risk is the same—the risk the land value will decrease.

Shareholder A is now the sole owner.

ABC now has financial leverage: Liabilities/assets = 80%.

Shareholder A has a much larger upside and downside.

First Bank has a much bigger downside than upside.

Without knowing First Bank’s assessment of the probability of the mall’s approval, we can’t determine the bank’s perception of its risk.

Similarly, we can’t determine whether this assessment is reasonable without knowing more about the context.

Take Away

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2525


Determine the investors’ expected returns at the time the land is purchased, assuming they believe there is a 50% chance the mall will be approved.

Evaluate the bank credit analyst who approved the loan.

Question: Part b5

Approv Not Approv Expected Approv Not Approv Expected

Probabilities 50% 50% ─ 50% 50% ─

Part (b)

Investment $800 $800 ─ $200 $200 ─

Payoff $880 $500 $1,120 $0

Gain/Loss $80 ($300) $920 ($200)

% Return on inv

BANK SHAREHOLDERFirst A

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2626


ABC’s investors’ expected returns are reported below.

Solution: Part b5


Probabilities 50% 50% ─ 50% 50% ─

Part (b)

Investment $800 $800 ─ $200 $200 ─

Payoff $880 $500 $1,120 $0

Gain/Loss $80 ($300) $920 ($200)

% Return on inv


$690 $560

($110) $360

10% -38% -14% 460% -100% 180%

The bank’s credit analyst gets a failing grade—the expected return is negative.

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2727


Determine the probability of approval needed for First Bank to expect to earn an 8% return on its investment.

Question: Part b6


Probabilities ─ ─

Part (b)

Investment $800 $800 ─ $200 $200 ─

Payoff $880 $500 $1,120 $0

Gain/Loss $80 ($300) $920 ($200)

% Return on inv 10% -38% 8.0% 460% -100%


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2828


The probability of approval would need to be 95.83%. This is the “p” that solves the following:

(10%) * p + (-38%) * (1-p) = 8%

Solution: Part b6


Probabilities 95.83% 4.17% ─ 95.83% 4.17% ─

Part (b)

Investment $800 $800 ─ $200 $200 ─

Payoff $880 $500 $864 $1,120 $0 $1,073

Gain/Loss $80 ($300) $64 $920 ($200) $873

% Return on inv 10% -38% 8.0% 460% -100% 437%


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2929


Given the 50% approval probability, First Bank could have done several things to structure the loan better:

Raise the interest rate considerably

If the interest rate had been 53.5%, First Bank would have expected an 8% return on the investment.

Require Shareholder A to pay a larger portion of the $1,000 investment, which lowers ABC’s financial leverage.

If the loan had been for $471.7 instead of $800, First Bank would have expected an 8% return on the investment.

Bad credit decisions often occur during real estate booms:

If the land price had recently increased from $500 to $1,000 because of risk seekers betting on mall approval or there was a real estate bubble, banks might have underestimated losses.

Take Away

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3030

Mall Exercise: One Shareholder & Two Banks

On 01/01/2009, ABC Company

Issues $200 worth of stock to shareholder A

Issues $800 worth of debt to First Bank with 10% per year interest

Issues $1,000 worth of subordinate debt to Second Bank, with a 15% rate

On 01/02/2009, ABC purchases two parcels land for $2,000

Next to planned shopping mall




For $1,000 if mall not approved


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3131


On 12/28/2009, ABC learns whether mall is approved



For $1,000 if mall not approved

On 12/31/2009, ABC distributes its cash to investors


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3232



Question: Part c1


If Mall approved



After financing

Assets


PP&E

Total assets


Debt


Common stock

Retained earnings




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3333


If Mall approved



After financing

Assets


PP&E

Total assets


Debt


Common stock

Retained earnings






Solution: Part c1

$0 $2,000

$2,000 $0

$2,000 $2,000

$1,800 $1,800

$200 $200

$0 $0

$200 $200

$2,000 $2,000

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3434



Question: Part c2


Part (b)

Investment $800 $800 ─ ─ $200 $200

Payoff $880 $500 ─ ─ $1,120 $0

Gain/Loss $80 ($300) ─ ─ $920 ($200)

Part (c)

Investment

Payoff

Gain/Loss

BANKS SHAREHOLDERFirst Second A

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3535



Solution: Part c2


Part (b)

Investment $800 $800 ─ ─ $200 $200

Payoff $880 $500 ─ ─ $1,120 $0

Gain/Loss $80 ($300) ─ ─ $920 ($200)

Part (c)

Investment

Payoff

Gain/Loss

BANKS SHAREHOLDERFirst Second A

$200 $200

$1,970 $0

$1,770 ($200)

$1,000 $1,000

$1,150 $120

$150 ($880)

$800 $800

$880 $880

$80 $80

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3636


If Mall approved



After financing

Assets


PP&E

Total assets


Debt


Common stock

Retained earnings






Solution: Part c3

$0 $2,000

$2,000 $0

$2,000 $2,000

$1,800 $1,800

$200 $200

$0 $0

$200 $200

$2,000 $2,000

$4,000

$0

$4,000

$2,030

$200

$1,770

$1,970

$4,000

$1,000

$0

$1,000

$1,000

$0

$1,000

$200

($200)

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3737


What has not changed in part (c)?

What has changed? Why?

Question: Part c4


Part (b)

Investment $800 $800 ─ ─ $200 $200

Payoff $880 $500 ─ ─ $1,120 $0

Gain/Loss $80 ($300) ─ ─ $920 ($200)

Part (c)

Investment $800 $800 $1,000 $1,000 $200 $200

Payoff $880 $880 $1,150 $120 $1,970 $0

Gain/Loss $80 $80 $150 ($880) $1,770 ($200)

BANKS SHAREHOLDERSFirst Second A

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3838


Shareholder A has the same downside but a bigger upside.

First Bank has no risk because Second Bank has effectively provided a safety cushion through subordination.

Second Bank’s credit analyst has made so many blunders; First Bank’s credit analyst has managed to escape a really bad deal.

When companies have nothing else to lose, they have a strong incentive to gamble with other people’s money.

Risk and reward go together when everyone behaves rationally.

Second Bank was not acting rationally, and as a result, Shareholder A’s and First Bank’s rewards increased, but not their risks.

Take Away

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3939

Closing Thoughts

The concepts and lessons discussed here were center stage in the 2007-2009 credit crisis:

Real estate prices increased dramatically in many areas of the world during 2005-2007.

Credit controls were very weak:

No down payments were required.

Customers without safety nets could barely make payments in good times.

Banks sold loans for a profit shortly after they were initiated, and thus, they had no incentive to control credit risks.

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4040

Closing Thoughts

Owners of Bear Stearns’ common stock realized the risks associated with financial leverage in March, 2008 when the value of their shares fell to $2 per share, after being worth more than $90 two months earlier.

Measured as liabilities divided by assets, Bear Stearns’ financial leverage was 97% on November 30, 2007 (the end of the fiscal year prior to the company’s downfall) and a good deal of its assets were very susceptible to risks associated with mortgages.

Towards the end of 2007 it became apparent that the risks associated with mortgages and related securities were considerably higher than most investors expected.

The compounding effect of Bear Stearns’ high financial leverage and high asset risk amplified the owners’ risk tremendously.

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11 making informed judgments part 5 risks and rewards application: shopping mall exercise and...

Documents

mall approved mall

approv mall approv mall

a2 mall approv mall

planned shopping mall

menu shopping mall exercise

menu slide

shareholders equity

shareholders ab return